The best stock to ride two megatrends In IT

Nigam Arora is an engineer, nuclear physicist, author, and entrepreneur and
the founder of two Inc. 500 fastest growing companies. He is also the developer
of the ZYX Change Method
to profit from change by investing. The premise is that most money is made by
predicting change before the crowd. Arora is the chief investment officer at
The Arora Report and the
editor of four newsletters that track the ZYX Change Method. Nigam can be
reached at Nigam@TheAroraReport.com.

Cloud computing and virtualization stocks are very expensive, face stiff competition and are subject to rapid technological changes. This poses a challenge for investors focused on risk adjusted returns.

Red Hat
RHT, -0.47%
is a hidden gem. The company provides open-source infrastructure software to the enterprises migrating to the two megatrends. Red Hat is the equivalent of a seller of picks and pans to the miners during the California gold rush. Our long-term estimates of growth rate and earnings power are significantly higher than the consensus estimates. The company is also an attractive acquisition target.

Red Hat is all about the change that is taking place; therefore it makes sense to analyze it in the context of the ZYX Change Method. The premise behind the ZYX Change Method is that the most money with the lowest risk is made by identifying change early. Here is how Red Hat measures up to our six screens.

Change screen

Cloud computing and virtualization have already become unstoppable. Most major corporations are enthusiastically embracing these two trends because of significant cost savings. Cloud computing, if done correctly, also provides a strategic advantage. Even the entities that are not enthusiastic are being dragged into these two trends kicking and screaming. This screen is highly supportive of taking a position in Red Hat.

Fund-flow screen

Our algorithms show that significant funds have been flowing into Red Hat, and we have detected heavy buying by the Smart Money every time this stock has pulled back over the last year. At present, our Smart Money indicator is neutral. Our interpretation is that as the stock pulls back, the Smart Money is likely to start buying this stock again.

Quantitative-analysis screen

The quantitative-analysis screen shows the stock is fairly valued at present, even though it is a very expensive stock from traditional fundamental measurements. The stock trades at a trailing P/E of about 76, but it is interesting to note that forward P/E is about half of the trailing P/E at 41. This means that earnings are growing rapidly. The company has enjoyed quarterly revenue growth (year-over-year) of over 18%.

If the current bull run in the stock market continues, using history as a guide, expensive stocks such as Red Hat that fit two hot themes are likely to become even more expensive by traditional measures.

ZYX change-analysis screen

This screen shows that Red Hat has cost advantage in both virtualization and cloud-computing markets. However, Red Hat faces competition from bigger companies with stronger sales forces.

Will Red Hat be able to use its cost advantage to successfully disrupt the market? The partial answer is that the probability of success is very high. Red Hat has a close relationship with IBM. IBM is also the most likely acquirer of Red Hat.

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